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Tokens Instead of Stock Options?

That was the idea put forth in a terribly misguided article on TechCrunch yesterday. In reading the article, it was painfully obvious that the author had no idea what a "token" is, let alone the potential IRS consequences of his suggestions. So first, at risk or boring my blockchain-savvy readers, let me elaborate on the main construct before I address the "stock options vs tokens" discussion..

What the heck is a "token"?

A token (aka "coin") is a digital representation of something. Just as a certificate is a paper representation of something. That something can be...

equity in a company

debt in a company

a combination of equity and debt

a fractional interest in real estate

a partnership interest

rights to royalties

a fractional interest in an automobile

movie tickets

a digital dollar (vs physical paper dollar)

your health records

credits to use in a video game or on a stock photo website

etc.

In other words, a token can represent anything, just like a paper certificate. It's a contractual right to something. Now, of course the world has already turned paper certificates into electronic certificates; Etrade doesn't hold your stocks, bonds and mutual funds in paper form in a big vault, and your bank doesn't set aside a pile of cash in a vault with your name written on it...that's all electronic. But turning those into e-certificates is a kludgey process, which in the securities world involves a company delivering a paper stock certificate to DTCC, registering shares with a transfer agent, and still hassling with paper certificates that some investors want to hold themselves. Whereas a token is born on a blockchain as a digital instrument.

So, should a company give employees tokens instead of stock options?

Well, it depends upon what those tokens represent. If they represent equity that's wholly owned, then it's likely a terrible idea as they would be taxable immediately upon issuance. Furthermore, whereas options align a company and its founding team, issuing equity straight-up (whether in the form of tokens or certificates) does the opposite as the owner might sell it immediately rather than work to increase value over time.

If the tokens don't represent equity then...well...what the heck do they represent and how do they motivate and incentivize people? Sure, founders and venture investors would LOVE to keep all the equity and just give people movie tickets or video game tokens, but that doesn't really keep the team focused on the mission at hand.

Furthermore, let's not underestimate tax issues. The IRS is one beast you do not want to fight with...nor serve your employees up on a platter to. If you give someone something of potential-value, such as stock options, then the strike price needs to be at current market value. If you give them something for less than current fair market price, then they owe taxes on it immediately, regardless of whether or not they can sell it. This has been a huge problem in Silicon Valley, where startups have given people stock grants (meaning wholly owned equity interests) or options with strike prices below fair value, with the result being massive tax bills on people who have no cash to pay them. Just because you haven't sold something doesn't mean you don't owe taxes on it, especially if it's given to you "free" or at a price below fair value. Whether there's a liquid market or not is irrelevant. Whether an employee can afford to pay the tax bill is irrelevant...they owe it, and the IRS will seize their bank accounts, their homes and their other assets to get those taxes if they aren't paid.

What's the answer?

First realize that a token is just a digital contract. It's not "tokens vs stock options" because a stock option can be tokenized, just like anything else. The appropriate question is "what do you want to give people? A right to equity, or something else?", then, from there, decide if you want to represent that contract with physical paper or a digital token.

To give someone a token that is a digital (instead of paper) blockchain-based stock option is tricky but can certainly be done. Just be careful of the tax issues and ensure that it means the holder has a right to exercise a future-purchase of equity based upon meeting some set goals, and isn't outright ownership and thus a taxable event. And to state the obvious, I'm neither a CPA nor a tax attorney, these tax rules and regulations are incredibly complicated, so you should go get advice from them on this; these are simply my observations and thoughts as a battle-scarred entrepreneur who's been through this many times.

Scott Purcell is the CEO and Chief Trust Officer of Prime Trust, the blockchain-driven trust company. His firm provides escrow, AML, KYC, payment processing, accounting, custody and compliance for numerous platforms, broker-dealers, investment advisers, portals and others who make a business of online capital formation.

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